Here is the thing about Uncle Sam - no matter what you do, he always gets his cut. As I learn more about investing for retirement and tax-minimization strategies, the "Pro-Rata rule" keeps popping up. As an FPMD reader, you probably don't have a lot of extra cash at the end of the month to dig deep into retirement strategies. But you soon will. Today I want to talk about the IRS "Pro-Rata rule," also known as the "cream-in-your-coffee" rule.

Background info

In order to understand the "Pro-Rata rule," it’s necessary to have a basic understanding of the taxability of retirement plan contributions. For example, let’s say you contribute to both a Traditional IRA account and a Roth IRA account. The contributions to each account will be treated differently by the IRS:

Traditional IRA contributions will be tax-deductible for people making an income below a certain level. Once it is in the account, it can grow tax free. But it will be treated as taxable income when you take a distribution in retirement. Because this contribution is deducted from your income before income tax is calculated, it is considered a “before-tax” contribution. Once you make more money than the income limit for deductions, your traditional IRA contributions become "after-tax". See below.

Roth IRA contributions are different, you pay income taxes on that contribution as you do on the rest of your income but once the money is in the Roth IRA, it will never be taxed again. Because this contribution is not deducted from your income before your income tax is calculated, it is considered an “after-tax” contribution.

What is the “Pro-Rata” Rule?

The “Pro-Rata” rule refers to how the IRS taxes the movement of “before-tax” and “after-tax” money in your retirement account(s). It is often referred to the “cream-in-your-coffee rule” because once you mix cream into your coffee, it becomes impossible to separate them again. The best way to understand how this works is via an example:

Say you have a traditional IRA that you have been contributing over the years and you have a total of $100,000 in the account consisting of $80,000 (80%) before-tax contribution and $20,000 (20%) after-tax contributions. Let’s say you want to roll over $10,000 of the $100,000 into a Roth IRA account so you can manage the investments more independently. Unfortunately, you will not be able to selectively roll over $10,000 only from your after-tax balance. Rather, the $10,000 will be treated 80% before-tax and 20% after-tax which means $8,000 will be considered taxable income. (Source: IRS)

Why does this exist?

The "Pro-Rata" rule exists to protect the interest of Uncle Sam. For example, to prevent abusive strategies where high income earners selectively roll over their after-tax Traditional IRA contributions into a Roth IRA for tax-free growth and distributions. While initially designed for IRAs (including Traditional, SEP, and/or SIMPLE IRA), the IRS has clarified this rule also applies to employer plan retirement plan distributions such as a 401(k) or 403(b). If your account balance contains both pretax and after-tax amounts, any distribution will generally include a pro rata share of both.

How to get around the "Pro-Rata Rule"?

For years, high income earners agonized over how to avoid the "Pro-Rata rule," leading to some creative, albeit questionable retirement strategies. Thankfully, the IRS clarified the way to avoid the "Pro-Rata rule" in Notice 2014-54. Basically what it says is that if you roll over the entire account as follows, you can avoid any tax consequences:

Before-tax amounts to a traditional IRA or another eligible retirement plan, and

After-tax amounts to a Roth IRA.

Following the cream-in-your-coffee analogy. What this means is while it is impossible to take a sip (partial distribution) without getting some cream in your coffee, if you pour the entire cup (entire account) down a magical sink, it will automatically separate the cream from the coffee into 2 separate containers.

Bottom Line

The "Pro-Rata rule" can become a landmine in your retirement planning if you have both before-tax and after-tax balances. So be sure to understand it before moving money in or out of your retirement plans. Despite the IRS Notice 2014-54, the topic of Roth conversion remains quite controversial and you may get different answers to the same question depending on who you ask. In the end, if it is something you would like to do and not sure about the legality of it, be sure to consult a tax professional.

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Dr. Bo Liu is an aspiring radiologist-in-training and the founder and editor of the White Coat Money Blog. He has an interest in interventional radiology and helping his medical colleagues get ahead in this mad world of medicine and money. When he's not crushing the list at the PACS station or typing up your next favorite blog post, you can usually find him at the local badminton club, movie theater or the most recently opened restaurant.

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